The direct lending market in the UK is undergoing some significant changes, with more private funds and sponsors making bigger loans. These funds are filling a void created by the withdrawal of some of the major banks. Banks began to limit credit loan issuance following the Ukraine crisis and rising interest rates.

Paul Hatfield, Former Global Chief Investment Officer at Alcentra, shared his view on what this means for the UK private debt market in a recent GLG teleconference. Below is a version of his talk, edited for brevity.

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Falling loan issuance affected both liquid and private direct lending and has created a demand for new deals from corporates. Direct lending has emerged as an attractive asset class for investors. Direct lending funds and private debt have replaced traditional syndicated loans in the market in many cases. Sponsors and direct lending funds still possess a substantial amount of dry powder, around a quarter of £1 billion, that needs to be deployed. This has prompted a sense of urgency to secure deals in the second half of the year, although the recent collapse of Silicon Valley Bank (SVB) has somewhat neutered this effect.

The rise in interest rates has further fueled the growth of direct lending. The floating-rate nature of this asset class has made it even more attractive to investors, resulting in significant capital inflows. Private equity credit arms, such as Apollo, KKR, and Oaktree, have witnessed substantial investments, driving greater market growth.

A notable trend in the direct lending market is the shift toward direct lending funds and private debt stepping into the shoes of traditional syndicated loans. This transition is evident in both the UK and Europe, where larger deals valued at £500 million and above are now being financed by private debt. This change has been accompanied by a decline in syndicated loan issuance and a rising preference for direct lending funds.

Banks have been reluctant to engage in leveraged lending due to profitability concerns. They have focused on other revenue streams, allowing direct lending funds to fill the gap. This shift is expected to continue as banks prioritize more lucrative areas and sit on their hands until the economy strengthens further.

Private equity has played a crucial role in driving direct lending activity. Major players, including Apollo, Blackstone, and BlackRock, have raised direct lending funds to capitalize on opportunities in the market. This dominance is unlikely to diminish anytime soon.

The macroeconomic outlook and potential risks remain important considerations. Rising inflation, although not as high as initially feared, still poses challenges for certain sectors. Food businesses and building product companies are particularly impacted by inflation, with significant increases in costs. The cost-of-living crisis and higher wages may also affect businesses, especially those heavily reliant on labour. There have been no reports of widespread defaults, but, anecdotally, there are signs of some private debt teams adding work out and distressed players to their staff in anticipation of further problem loans.

In terms of the UK’s political landscape, the government is still dealing with the fallout from the fiasco with Trussonomics, named after the extremely short-lived tenure of the former Prime Minister. People are still waiting to see what the full effects of Brexit are, how long these last, and where interest rates go. The government has shown a general inclination to loosen regulations to promote economic growth. However, with less than two years before the next election and likely changes in government — if you believe the polls — the impact of these measures may be limited in the short term.

If a centrist government is elected, investors should be comfortable. Given what the UK has had in terms of political instability over the last 18 months or so, investors largely will welcome a stable government.

Despite the uncertainties of politics, there is a positive outlook for the direct lending market. With substantial reserves and improved valuations, direct lending funds and private equity firms are expected to deploy capital and engage in more deals in the second half of the year. The UK market is anticipated to be more active than its European counterparts.

As the market evolves, risks such as geopolitical tensions, particularly regarding Ukraine, and the impact of sanctions on certain sectors may emerge. These factors could introduce unpredictability into the market.

Overall, direct lending activity in the UK is driven by a combination of elements, including the decline in bank loan issuance, the attractiveness of the asset class in a rising rate environment, the shift toward private debt, and banks’ reluctance to engage in leveraged lending. These drivers, along with strong investor demand, are shaping the landscape of direct lending in the UK.

Much will depend on how Ukraine plays out, which continues to have an impact on certain sectors and feeds inflation.

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Paul Hatfield, Former Global Chief Investment Officer at Alcentra

Paul Hatfield is an independent consultant (2018–present). Previously, he was Global Chief Investment Officer at Alcentra (2003–2018). Before this, Paul was Senior Analyst at Intermediate Capital Group (2002–2003) and Vice President, Leveraged Finance at Deutsche Bank (1995–2001).